The case for another rate cut in February

As Wayne Swan was at pains to point out, this week’s December quarter inflation numbers leave room for further interest rate cuts “into the future".

But as the Treasurer also readily conceded, there is nothing he can do in the short term to make the banks pass the cuts on to borrowers. For that reason, the Reserve Bank is likely to end up cutting its official cash rate by more than it otherwise would, as the commercial banks use the cuts to maintain their rates of return against the rising cost of overseas money.

The question now exercising the markets is when.

The market was spooked when the underlying inflation rate, at 2.6 per cent, turned out to be slightly higher than it expected – and a lot higher than the more optimistic forecasts of markets economic advisers. But the majority of economists are still plumping for another 0.25 percentage point cut in the cash rate next month.

The reason is that, although the timing may not be critical, the RBA almost certainly has more work to do. While the risks of a major disaster in Europe appear to have eased, they are still high. The International Monetary Fund’s Christine Lagarde is still warning of a “1930s moment" if enough money is not found to support the euro area’s ailing governments.

True, the IMF says the euro area economies should escape with a relatively mild recession, but its forecast is based on a lot of things going right. And you don’t have to embrace the disaster scenario to accept that Europe’s recession could be worse than the 0.5 per cent 2012 contraction suggested by the IMF.

Europe’s crisis economies are facing up to massive fiscal consolidation and structural reform that will subtract from growth before it adds to it.

The IMF’s ideal of growth-friendly fiscal consolidation includes a boost to growth from trade as a result of the accompanying currency depreciation. But for the euro that’s a pretty limited option.

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And, while there has been a marked improvement in the US economic data, the new statement by the Federal Reserve, that its monetary policy rate will stay close to zero until the end of 2014, is a reminder that the US faces a long, slow recovery.

In the meantime, the Northern Hemisphere’s woes are being transmitted to the Australian economy through, among other things, the higher cost of wholesale funds. UBS economist, Scott Haslem, argues that “amid a rising [Australian dollar] and bank funding costs, this together suggests the ‘path of least regret’ for the RBA is to trim rates to ward off further tightening in domestic monetary conditions".

The Australian economy certainly has its soft spots outside the magic circle of the miners and their satellite industries. Retailing, which is the biggest private sector employer, manufacturing, and housing construction are among the sectors doing it tough.

Employment is estimated to have fallen sharply in December, reducing the jobs growth for 2011 to nothing.

The unemployment rate is still low at 5.2 per cent, and the Australian economy is expected to build momentum in coming months, spurred by, among other things, the RBA’s rate cuts in November and December. But in a weaker world economy, it is not difficult to imagine the unemployment rate going above the 5.5 per cent forecast by the Treasury and, contrary to the RBA’s expectations, staying elevated for a prolonged period.

As always, the hardest hit would include the young, unskilled workers who, in any kind of downturn in the demand for labour, are in effect frozen out of the labour market.

BT Financial Group’s Chris Caton warns that “if the RBA is concerned enough about the global economy and about the flattening of jobs growth in Australia [and it should be], then there is room to provide more support."